Islamic Aircraft Financing

Islamic finance is broadly perceived as a way of managing money by taking into account Islamic religious requirements – Namely the Shariah. Shariah generally refers to the laws derived from the Qur’an and the Sunnah and provides guidance to Muslims in the way that they conduct themselves in their daily lives.

The Qur’an and the Sunnah outlines some basic principles in performing business transactions but it can be seen that such principles are difficult to reconcile with the modern day banking system. As such, contemporary Muslim scholars have established certain principles which are Shariah compliant and which are also relevant to the present banking system. Such Shariah principles are the cornerstone of Islamic finance practices and will be considered in further detail below.

Fundamental themes

Before considering the different types of Shariah compliant structures which can be used in aircraft financing, it would be useful to first understand some of the basic principles that differentiate Islamic financing from the conventional (i.e. interest bearing) method.

One of the most important tenets of Islamic finance is the prohibition of "riba", which in simple terms, means "extra" or "excess". This prohibition against excesses has been interpreted by Islamic scholars to mean a prohibition against the charging or receipt of any interest. As a result, interest is banned in all types of Islamic transactions.

Islamicbanking is also an asset-backed system. Shariah does not recognise the time value of money. Money has no intrinsic value and is simply perceived as a medium of exchange. Under Shariah, it is believed that profits should only be generated as a result of a business activity or when a commodity is traded.

Another key feature of Islamic finance is the prohibition of gharar (uncertainty and ambiguity) in contacts which makes conventional speculative transactions (such as derivatives, futures and insurance) difficult to reconcile with Shariah.

There are also certain activities which Shariah deems as haram (forbidden) such as dealing with weapons, gambling, alcohol and pork.

Common Structures in Aircraft Financing

Ijarah

An Ijarah refers to an arrangement where the owner/lessor enters into an agreement to transfer the right to use a certain asset to another person in consideration for prescribed rental payments. An Ijarah contract is equivalent to a conventional lease agreement and is therefore a popular choice in Islamic aircraft financing.

Some of the basic principles in an Ijarah contract are, amongst others, that the asset has to be of valuable use, that all risk of ownership is borne by the lessor and all liabilities arising from the use of the asset is borne by the lessee.

Istisna’

Istisna’ is a contract between a seller and a buyer for the sale of an asset which has yet to come into existence. It is commonly used in manufacturing or construction contracts. The seller can either manufacture or construct the asset itself or can procure the same and arrange for the delivery to the buyer on a specified date. This method is useful in circumstances where the aircraft is purchased directly from the manufacturer and the financing is put in place before the aircraft has been completed.

Commodity Murabahah

In a commodity murabahah transaction, a seller will agree with a buyer to provide specific commodities at a pre-determined price. The basis of a murabahah transaction is that the seller will disclose to the buyer the actual cost he has incurred in acquiring the commodities and the profit which he will make following the sale.

The commodity murabahah is one of the most favourable structures amongst borrowers. It provides borrowers who want to undertake Shariah compliant fund raising with a simple method of doing so and without having to use any of their own assets (as compared to an Ijarah structure). The commodity murabahah can be easily utilised to finance an acquisition of an aircraft.

Qard Hassan

The Qard Hassan is the only type of loan which is recognised as being Shariah compliant. It is a benevolent loan and obliges the borrower to repay the lender the sum borrowed on maturity of the loan. When repaying, the borrower has the discretion to reward the lender for granting the loan by paying a sum over and above the amount borrowed. Note, however, that it is important for the borrower to have the discretion to pay any additional sums and that he cannot be bound under an agreement to do so. As such, the Qard Hassan is clearly not favoured by lenders as they are not able to secure their returns.

Security

The type of security which a lender can take in an Islamic aircraft financing does not differ very much from the type of security available to conventional lenders. It is common for Islamic financiers to take security in the form of mortgages, assignments, charges and pledges – much like their conventional counterparts.

Further, under an Islamic structure, it is possible to appoint a security trustee to hold the security on behalf of the Islamic financiers (in the same way as this is done in a conventional financing) as the concept of a trust is widely accepted.

Islamic Aircraft Financing in Practice – The Ijarah

We will now consider how an Ijarah structure can be utilised for a purchase of a new aircraft.

1. The airline will normally enter into a sale and purchase agreement with the manufacturer for the purchase of a new aircraft at an agreed purchase price (the "Purchase Price").

2. The airline will then enter into a lessor purchase agreement with a special purpose vehicle for the purposes of the financing structure ("SPV 1"). Under such lessor purchase agreement, the airline will transfer the beneficial interest in the aircraft to SPV 1 for an amount which is equivalent to the Purchase Price.

3. SPV 1 will then enter into an Ijarah arrangement with the airline in which SPV 1 will execute a lease agreement with the airline to lease back the aircraft to the airline and the airline will pay lease rentals to SPV 1. The lease rentals will be equivalent to the principal and interest on the “loan” obtained by the airline from Islamic financiers to purchase the aircraft.

4. In order to finance the purchase of the beneficial interest in the aircraft, SPV 1 can enter into a mudharabah arrangement with another special purpose vehicle ("SPV 2"). Under the mudharabah arrangement, SPV 1 and SPV 2 can agree to share the profits derived from the purchase and leaseback of the aircraft at certain agreed ratios. Essentially, the profits to be shared will be the “interest” portion of the “loan” extended to the airline from the Islamic financiers to purchase the aircraft.

5. SPV 2 will then enter into an investment agency agreement with the Islamic financiers wherein the Islamic financiers will appoint SPV 2 as the investment agent in the mudharabah arrangement.

6. The above transactions may be illustrated as follows:

This article is part of the Aviation Bulletin for February 2013.

Other articles in this Bulletin include:

> The passenger as master of the journey: connecting flights under the 1999 Montreal Convention